Iron fires up, but for how long?

Summary: Chinese demand, acquisitions and new investments have spurred a price rise.

Key take-out: Investors need to weigh up the factors that have pushed iron ore higher.

Iron ore continues to shake off a mid-year slump, thanks to rising prices, deal flow and investment in new mines.

These events are refreshing interest in the sector, but whether it can continue is a question that is worrying some investment bankers.

A 20 per cent price rise since July to $US76.48 a tonne for ore containing 62 per cent iron, the benchmark grade, means that technically iron ore has re-entered a bull market.

The latest price represents a 12 per cent increase on the $US68/t when Eureka Report last looked at iron ore in early August (Iron ore swims against an outgoing tide, August 10), with doubts then that an already impressive price rise could be sustained.

For BHP and Rio Tinto, which both produce ore that meets benchmark specifications, the higher price should be flowing directly into their bottom lines.

Other producers, including Fortescue Metals and Mineral Resources, are getting only a proportion of the price, because their lower-grade ore attracts hefty discounts from Chinese steel mills.

It’s the discounts which cloud a clear view of the iron ore sector, because they can vary widely and fluctuate as steel mills adjust their operating times and raw material mix. That’s largely as a result of tough new environmental pollution laws in China and a rush to make as much steel as possible ahead of a forced winter slowdown when air-pollution is at its worst.

There is also uncertainty about whether the Chinese Government is encouraging a shift in steel milling from material used in appliances and vehicles (coil) to construction-grade reinforcing bar (rebar) ahead of a stimulus program to offset the effects of falling exports of manufactured goods to the US.

A simple test of the complex forces at work in iron ore is that while the benchmark price is up 20 per cent, the share price of Fortescue has fallen by 15 per cent over the same time. A recent share-price uptick was more attributable to a $500 million share buyback than to confidence in future profits.

In its September quarter report released last week Fortescue said the average price for its ore was $US45/t, which was 67 per cent of the benchmark price during the quarter. It was a modestly better return than in the June quarter, but the benefit was offset by an 8 per cent increase in costs to $US13.19/t.

Fortescue is trying to shake off its reputation as a low-grade producer by investing in new and higher-grade mines such as the Eliwana development, but it’s making that investment at the same time that BHP and Rio Tinto are also investing in new mines to replace ageing assets.

Multiple mine expansions in Australia and overseas mean that there is unlikely to be an iron ore shortage in the future, especially as the overall rate of steel production appears to have peaked after the China-led boom of the past two decades.

Positioning for demand growth

Mineral Resources, a company better-known as a supplier of engineering and mineral processing services, is an interesting example of a company which believes iron ore still represents a worthwhile investment.

It is using the uncertainty in the outlook to make a series of small investments which could lead to something bigger.

Already a marginally profitable iron ore miner with an interest in two small projects, Carina in the south of WA and Iron Valley in the north-west, Mineral Resources has recently completed two asset acquisitions, is finalising a third, and failed earlier this year to secure a fourth.

The deal-spree started in April when Mineral Resources joined the bidding for Atlas Iron, which has been acquired by Hancock Prospecting. This was followed by the acquisition of the Koolyanobbing mine from the US owner, Cleveland Cliffs, a plan to buy a 50 per cent stake in the undeveloped Marillana project from Brockman Mining, and the purchase of the Kumina project from BC Iron.

None of the assets going into the iron ore operations of Mineral Resources is big, but collectively they could represent the foundation of a substantial business, especially if they can share rail and port infrastructure to keep costs low.

Investors seem to be wary of the iron ore plans of Mineral Resources and also appear to be concerned about a major investment in lithium production as the price of that material slides under the weight of excess supply.

Earlier this week the share price of Mineral Resources dropped to a 12-month low of $13.72, down 35 per cent on the $21.33 price at the start of the year.

Much of what’s happening in Australian iron ore is a result of events unfolding in China, including the pre-winter surge in steel production, changes to the type of steel being made to manage the effects of the trade war, and limits on China’s domestic iron ore output.

Macquarie is one of several investment banks keeping a close eye on events in iron ore, describing the latest increase in the price as surprising. “Investors are asking us what’s going on?”

Three possibilities for the price increase were examined by Macquarie; the pre-winter steel-making rush, cost management which has seen a change in the discount structure, and capacity utilisation which has seen some steel mills boost output to avoid being targeted by the government for closure as part of an industry-wide program of rationalisation.

ANZ, in its latest commodity outlook, said the iron ore price would probably stay at around $US70/t for the next two quarters thanks to events in China.

However, the overall iron ore trade was not growing as rapidly as it once did with global seaborne trade expected to expand by just 10 million tonnes this calendar year, an insignificant amount in a billion tonne annual business.

A three-way iron ore split

For Australian investors with an ongoing interest in iron ore, there is a three-way split developing.

At the top of the totem pole are the traditional sector leaders, BHP and Rio Tinto.

Fortescue Metals is on the next run down thanks to its tight cost controls offsetting a lower-grade product.

At next level are special situations that include Mt Gibson Iron, a very small producer of ultra-high-grade ore from its Koolan Island mine which is being redeveloped after a flood

And then there’s Mineral Resources which is trying something new through its acquisition of smaller iron ore assets and the discards of companies exiting the business.

For an industry which came off its peak a few years ago iron ore remains an interesting business as factors other than simple supply-and-demand dictate price moves, and it’s those uncertainties which mean it is also a riskier business than a few years ago.